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Fannie Mae and Freddie Mac: What They Do and Why We Need Them

A lot of news stories today have to do with Fannie Mae (NASDAQOTCBB: FNMA) or Freddie Mac (NASDAQOTCBB: FMCC) , which have both become household names as a result of the mortgage crisis. However, even though these are both very well-known companies, not very many Americans really know what the companies do and why they were created.

With that in mind, here's a crash course in the two companies to help investors improve their understanding of Fannie Mae and Freddie Mac.

A brief historyFannie and Freddie are both government-sponsored enterprises, or GSEs, that buy mortgages on the secondary market, pool them together, and then sell them as "mortgage-backed securities" to investors. The goal of these companies was to increase the supply of money available for mortgage lending and, therefore, increase the money available for home purchases.

Fannie Mae was created as part of the New Deal in 1938 in response to the Great Depression in an attempt to stimulate the housing market. Fannie Mae split in 1968 into a private corporation and a publicly financed institution, which became known as Ginnie Mae. The difference was that Ginnie Mae explicitly guaranteed its mortgages, while Fannie Mae did not, but it was implied that the government would guarantee the loans.

Freddie Mac was established by Congress in 1970 in order to provide competition for Fannie Mae and to further boost the availability of funds for mortgage lending. Both companies are only allowed to buy "conforming" loans, which meet certain size limits that are set in relation to the mean home price.

The financial crisis and Fannie and Freddie's rolesEven today, it remains unclear just how much blame for the most recent financial crisis should be placed on Fannie and Freddie. There are still ongoing investigations by the Justice Department that aim to determine just how much financial institutions misrepresented the quality of their loans that they sold as "investment grade." Some of these investigations have already found wrongdoing by the banks and have awarded large settlements to the GSEs.

For example, Deutche Bank just recently agreed to pay $1.9 billion to the GSEs ($1.63 billion to Freddie Mac and $300 million to Fannie Mae) in response to accusations that the bank misled both companies about the quality of $14.2 billion in mortgage-backed securities. Earlier this year, Bank of America agreed to pay $3.55 billion to Fannie Mae and to repurchase $6.75 billion in questionable mortgages. The list goes on and on...

In a nutshell, banks began to use lower lending standards in order to make more loans and boost earnings, and at first, they didn't meet the standards of Fannie and Freddie, so private mortgage-backed securities (MBSes) became more commonplace. This took business from the GSEs and forced Fannie and Freddie to drastically lower their standards to reclaim the market share they were losing in order to keep their profits fat for their private shareholders.

As we now know, this was unsustainable, and by 2008, the companies owned or guaranteed over $5 trillion in mortgage debt, a lot of which was substandard. The share prices of both companies began to drop drastically, and investors were fearful of a collapse amid skyrocketing foreclosure rates and plummeting housing prices, worrying that the companies lacked the capital to absorb the predicted losses.

In September 2008, both companies were placed into conservatorship of the FHFA, and the Treasury was issued preferred shares and warrants for a 79.9% stake in each company, which effectively ended the implicit guarantee and made both Fannie and Freddie into government-operated companies.

Fannie and Freddie todayThe basic role of Fannie and Freddie has not changed very much. The companies still guarantee and purchase loans from mortgage lenders, and the companies have taken steps (including raising fees) in order to improve their financial condition and build a profitable business.

According to Fannie Mae's website, between 2009 and the present, the company provided about $3.9 trillion in liquidity, which enabled 3.4 million purchases and 12 million refinancings. Freddie Mac says that they have provided $2.1 trillion of funding since 2009, including purchases and refinancings.

One aspect of the GSEs' business that was not really there before the crisis is loan modifications, designed to help borrowers stay in their homes and avoid foreclosure. Since 2009, Fannie Mae has modified over 1 million loans and has implemented programs to reach those at risk.

Currently, more than three-quarters of the mortgage loans being made in America are subsequently guaranteed by Fannie and Freddie, so odds are that if you financed your home, your loan is guaranteed by one of these companies, even if you don't know it.

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Matt brought his love of teaching and investing to the Fool in order to help people invest better, after several years as a math teacher. Matt specializes in writing about the best opportunities in bank stocks, real estate, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!
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